The creation of the euro as a currency was one of the boldest moves in the history of finance, tying together with a monetary bond many of the nations of Europe that had been at war on and off for centuries. The trouble is that the tie doesn’t extend far enough. Individual countries are still responsible for their own budgets and debts, and some of them, including Ireland, Portugal, and Greece, have had to be bailed out by their stronger euro zone affiliates in order to avoid defaulting on their bonds. Greece is now seeking to replace its initial helping of bailout funds with a fresh rescue package.

Sovereign defaults weren’t supposed to happen when the euro came into being as a currency. But an over-reliance on debt by several European nations and a long stretch of economic weakness have brought the situation to a boil.

In the near term, keeping countries on the periphery from defaulting is the key to keeping the debt crisis from spiraling out of control. That is being accomplished through the implementation of the European Financial Stability Facility, created in May, 2010, to pass along bailout funds to struggling nations. 

So far, the threat of default has been limited to smaller nations on the periphery of the euro zone. But if a recession were to take hold in Europe, larger economies, such as those in Spain and Italy, might experience difficulties to the point where financial assistance was required. Second-quarter GDP in the euro zone recently registered a scant 0.2%, and growth projections for the second half of 2011 are being scaled back. Current plans to expand the Stability Facility are dependent upon approval by the parliaments of member nations.

Longer term, steps need to be taken to bind euro zone members closer together. Coordinated fiscal, political, and economic policies are needed to effectively make the European Union a United States of Europe. Euro bonds, which would probably be highly rated, could then be sold, rather than the individual nations issuing their own bonds. But binding nations together in this manner means they must give up a measure of their sovereignty, which will be difficult for a number of them to accept. Anti-euro sentiment is already on the rise in Finland, which has demanded collateral for the latest Greek bailout. The people of stronger nations, such as Germany, may not be convinced that pooling their interests with less fiscally sound neighbors is in their best interests, either.

In the absence of successful bailouts in the near term, and longer term initiatives to turn the European Union into a more closely knit group, the breakup of the euro zone is a possibility. This scenario would be highly disruptive, since it would most likely mean that one, or more, countries had defaulted on their debt. That, in turn, would create disincentives for banks to lend as they lick their wounds on losses incurred from sovereign debt holdings. Further economic backsliding would be almost assured. 

The added worry is that the fallout from Europe’s sovereign debt troubles could be transferred to the United States through the banking system or through money market funds. A number of European banks are reliant upon money markets based in the United States for funding. Lately, money market managers have been limiting their purchases of short-term holdings in Europe to the core nations of Germany, France and the Netherlands.

Meanwhile, major banks in this country, such as Bank of America (BAC - Free Bank of America Stock Report), JPMorgan Chase (JPM - Free JPMorgan Chase Stock Report), and Citigroup (C) have indicated that their levels of exposure (about $45 billion in total, roughly evenly split among the three as of June 30th)  to European countries experiencing credit deterioration are manageable. But U.S. banks also have less-well-defined indirect exposure to financially troubled countries in Europe through guarantees or holdings in banks in other nations, such as France or Germany, that are likely to be invested in the Continent’s distressed countries. The interconnectedness of the financial system and the possibility of a domino effect if a European nation is allowed to default on its bonds are making investors nervous. The good news is that banks on both sides of the Atlantic are better capitalized and have more liquidity than was the case in 2008. That will soften the blow in the event of an unfavorable outcome in Europe.

The hurdle in the coming weeks will be to shore up Greece’s finances, against the backdrop of rising contentiousness within the European Union and a possible recession looming. However, selling austerity measures as a cure to economic problems in a region that was once considered home to the world’s most advanced civilization is proving no easy task. All told, investors may well be on edge for some time, given their extremely high aversion to risk of late and the unsettled nature of the problems in Europe.

At the time of this article, the author did not have positions in any of the companies mentioned.